Trade credit advantages and disadvantages

Understanding trade credit advantages and disadvantages is crucial to helping you decide whether you should offer trade credit to customers or use trade credit when buying supplies for your business.

Trade credit can be a lifeline for business cash flow, but there are plenty of trade credit pitfalls to know about.

In this article we’ll outline what trade credit is, the different types available, and the various advantages and disadvantages for both buying businesses and suppliers.

Like all finance types, it’s a good idea to seek independent specialist advice to ensure that trade credit is the right type of finance for you and your business.

What is trade credit?

Trade credit is where one business provides a line of credit to another business for buying goods and services.

For example, a garden landscaping business might use trade credit to buy materials for a landscaping project, buying on credit and promising to pay within a set term – often 30 days but can be as long as 90 days.

This makes trade credit a short-term source of finance.

Some businesses, such as those operating in the construction or retail industries, rely so heavily on trade credit that their business model might not work without it with so much cash being tied up in materials and stock before any money comes in from customers.

As a business, you can offer trade credit to other companies and also use trade credit facilities offered by other companies.

Trade credit is less formal than a loan from a bank, though there are usually terms and conditions attached, including penalties and interest for late payments.

Trade credit is a mutually beneficial arrangement – customers are able to buy goods on credit, and suppliers can attract more customers by not demanding cash up front.

Trade credit advantages and disadvantages are different depending on whether your business is the buyer in the agreement and using trade credit, or a supplier of trade credit.

Before accepting trade credit, it’s best to know the positives and negatives of any agreement.

How does my business obtain trade credit?

Getting trade credit, where you buy now and pay later, isn't a guarantee from suppliers.

Here's how it works:

Suppliers have a team that decides if you can buy on credit.

They use special methods and tools, like software that predicts if you're likely to pay back.

To check if new applicants are good for credit, suppliers look at three main things - often called the 3 C's:

• Capacity: Can you pay?
• Character: Will you pay?
• Capital: Do you have the financial backing?

They also look at your financial health through documents like your balance sheet and your history of paying bills.

Companies like Experian and Equifax offer credit reports that rate how trustworthy you are with money, including how quickly you pay off bills.

Nowadays, there are even tools using machine learning to figure out if you're a safe bet for trade credit automatically.

If you don't get offered trade credit, you're not out of options.

You can still buy goods by paying cash on delivery, which means you pay for your goods as soon as they arrive.

If your business has been deemed creditworthy, the process of a business obtaining trade credit via open account (which is the most common type of trade credit) is straightforward:

1. The sale between the businesses is completed with the buyer agreeing the payment terms with the seller but not making any upfront payments
2. The seller ships the order to the buyer
3. The buyer receiving the order alongside an invoice from the seller
4. The buyer pays for the goods on an agreed upon date.

What are the different types of Trade credit?

Trade credit is essentially a way to purchase goods or services now and pay for them at a later date, usually within an agreed-upon timeframe.

While there are various types of trade credit, the exact details can differ based on the agreement between the buyer and the supplier.

Open account credit

The simplest and most popular type of trade credit works like this: a supplier lets a buyer obtain goods or services now without having to pay right away.

Once the goods are delivered, the buyer gets an invoice with a due date for payment, which is usually set for 30, 60, or 90 days later.

This gives the buyer some time to pay for their purchase.

Revolving credit

This trade credit functions much like a credit card.

The supplier sets a maximum spending limit for the buyer, who can then buy goods or services up to this limit.

The buyer is required to make regular payments, often monthly.

With each payment, the amount of available credit is replenished, allowing the buyer to continue making purchases up to their limit.

Read more about Revolving credit.

Trade acceptance

Sometimes, the supplier might create a bill of exchange, also called a trade acceptance.

This document sets a future date by which the buyer needs to pay for the goods.

By accepting this bill, the buyer promises to pay the specified amount on or before that due date.

Instalment credit

In this arrangement, the buyer commits to paying off their purchase in scheduled instalments over a set period.

The supplier might ask for an upfront down payment and then split the rest of the cost into equal payments.

These payments are then made according to a pre-arranged schedule.

Cash-on-Delivery

Also known as COD, the buyer pays for their goods or services at the point they receive them.

This means the supplier gets paid quicker compared to other methods, like Open account credit, which lowers the risk of not getting paid at all.

However, the downside for the buyer is that they need to pay up before they have the chance to earn any profits from what they've bought.

Consignment credit

In a consignment deal, the supplier sends goods to the buyer but keeps ownership of them until they're sold by the buyer.

This setup means the buyer only pays for items once they sell, lowering their risk.

Essentially, if the goods don't sell, the buyer isn't out of pocket for unsold inventory.

Advantages of trade credit for buyers

While there are some trade credit disadvantages for buyers, there are more advantages for businesses looking to use trade credit to buy goods, materials, and services without having to pay up front or on delivery.

Benefits range from accessibility and cash flow advantages to helping new start-up businesses get off the ground.

Help start-up businesses get up-and-running

Trade credit can be useful for new businesses unable to raise funding or secure business loans, yet need stock quickly.

However small businesses can be hamstrung by a lack of trading history which makes obtaining trade credit difficult.

Get a competitive edge

Buying goods as required on credit gives businesses a competitive advantage over rival firms that may have to pay upfront.

Using trade credit allows your business to be more flexible, adapting to market demands and seasonal variations so that you have a constant supply of goods despite any fluctuations in your finances.

Fuels business growth

Trade credit can be one of the best ways to keep cash in your business, effectively providing access to working capital at minimal cost.

There’s usually less administration compared to arranging a short-term loan.

Think of trade credit as an interest-free loan.

It’s one of the best ways to keep cash in your business, effectively providing access to working capital at no cost.

There’s less administration compared to arranging a short-term loan.

Easy to arrange

If your business has a good credit history, is able to meet a supplier’s requirements and has the ability to make regular payments then trade credit agreements are typically easy to arrange and maintain.

There are usually few formal arrangements or negotiations to complete, making it quick-&-easy to use.

Increases your business’s reputation

Demonstrating your business can make regular payments against credit is a good way of establishing and maintaining it as a valuable customer.

A good trade credit history can mean suppliers treat you as a preferred buyer.

Discounts and bulk buying

Suppliers may offer appealing discounts to trade credit customers who pay early, making it a useful way to obtain a discount.

Businesses with a good trade credit history may be offered discounts, especially for bulk purchases, or exclusive access to goods and services.

Advantages of trade credit for sellers

For suppliers, trade credit is all about winning new customers, increasing sales and retaining customer loyalty.

Winning new buyers

Buyers like trade credit.

It’s an easy way to ease cash flow, which can help improve a small business’s profitability.

As a supplier, offering trade credit is a useful tactic to win new customers – especially if competitors insist on payment upfront.

Sell more goods and services

Suppliers can mix trade credit with bulk discounting to encourage buyers to spend more.

If buyers quickly sell out of stock, they are more likely to return and buy additional stock to meet customer demand.

Improve buyer loyalty

Supplier trade credit can prevent buyers from looking elsewhere and strengthens the supplier-buyer relationship.

Trade credit relies on trust between the two parties, good communication, and a mutually-beneficial relationship that can reinforce loyalty.

Disadvantages of trade credit for buyers

While there are fewer downsides, in terms of trade credit, for buyers than suppliers, there are still potential drawbacks that are worth understanding.

Access to free credit can seem like a lifeline for a cash-strapped business but if the fundamentals of your business mean you’re likely to miss repayments, you might want to think again about relying on trade credit.

Hard to obtain for startups

Trade credit seems perfect for startups.

Access to stock without upfront payment could help get your business up-and-running.

However, trade credit is significantly harder for new businesses to obtain or it may be offered on restrictive repayment terms.

Until your business has established itself and built up a consistent trading history, some suppliers will be reluctant to offer your business trade credit.

Penalties and interest

While trade credit can initially seem like ‘free money’ and can be repaid without interest, missing repayment deadlines can turn what seemed like ‘free money’ into ‘expensive debt’.

Most trade credit terms and conditions include penalties for late payments and interest payable on outstanding credit.

This can quickly spiral into significant costs if your business doesn’t work to clear trade credit debts.

Legal action

Fall behind on trade credit payments and your business could face legal action, which could culminate in a court judgment, which will impact your credit rating.

If the judgment debt is not paid, this could result in enforcement action which may include goods and assets being seized to pay outstanding bills or even insolvency proceedings.

Some trade credit terms and conditions include what is known as a “retention of title” clause, which could enable the supplier to take back all goods it has supplied if any payment is missed.

Negative impact on credit rating

Prompt repayment of credit is good for your business’s credit rating; missed deadlines and late payments can quickly harm your rating.

That can have an impact when your business later seeks to raise finance such as obtaining a small business loan, as a poor credit rating can affect the amount of interest you’ll have to pay or even if you can secure a loan in the first place.

Loss of suppliers

When faced with a poor-paying buyer, suppliers may be tempted to cut their losses and refuse to work with your business.

Suppliers can pull the plug on working with you, leaving your business unable to operate or meet customer demand – potentially resulting in the closure of your business.

Disadvantages of trade credit for suppliers

The bad news for suppliers is they tend to carry a larger part of the risk in the trade credit advantages and disadvantages equation.

While there are lots of routes open to deal with problem buyers and getting back money your business is owed, these can be time-consuming and costly – potentially impacting your cash flow and causing financial problems.

They are also not guaranteed to result in full repayment (for example, if the buyer has become insolvent).

Late payments

Buyers paying late is the major problem suppliers face when offering trade credit.

Depending on your industry, be prepared that most buyers will sometimes pay late.

Cash flow problems

Late payments or buyers simply not paying at all can lead to serious cash flow problems for suppliers.

With the need to pay their own outstanding bills, suppliers can be effectively caught between demands from creditors for payment and chasing after buyers for overdue cash.

Ensure your business has a strong cash reserve and doesn’t overextend on credit.

Offering discounts to buyers who make early repayments can also help alleviate cash flow problems caused by late payers.

Bad debt

Late payments are one thing, but non-payment can present a serious challenge.

Customers using trade credit may go out of business or payment may simply be too difficult to chase down, which means your business will need to write off the loss as a bad debt.

It’s worth investigating trade credit insurance, which can insure your business for bad debt caused by defaults on trade credit agreements.

Customer assessment

Offering trade credit is an act of trust.

Assessing whether a customer has the means to repay you is worth doing right, but determining a buyer’s credit worthiness can be time-consuming.

You’ll need to check references, obtain credit reports and review trading history – all of which takes time.

Account handling

Offering trade credit involves a lot of paperwork and administration.

As a supplier, you should consider getting professional legal help to write terms and conditions, and you’ll need dedicated account handlers to ensure that outstanding invoices are chased up.

Setting clear invoice terms and ensuring good communication can help encourage buyers to pay promptly and regularly.

You may want to investigate online accounts software with CRM and invoicing – they often include free alerts when invoices are due.

What is credit insurance?

If a business can't pay back its debts, it can have a catastrophic impact on not only the business itself, but also its suppliers.

That's where credit insurance comes in handy.

This type of insurance is there to help protect suppliers if they don't get paid on time, or at all, for the products or services they've sold on credit.

It's not rare for businesses to find themselves unable to pay their bills, a situation known as insolvency.

Having credit insurance means a supplier can relax a bit, knowing that the financial concerns of other businesses, or even wider economic conditions, won't have a negative impact on them too.

Beyond just dealing with late or missed payments, credit insurance offers a safety net against bigger issues like changes in global trade patterns or new rules from the government that affect how a business operates.